• Money supply (M2) skydives
• Banks are reporting falling Loan-to-Deposit ratio
• Slowdown in lending will lead to layoffs/bankruptcies
  
  

The only times when the money supply was that negative was on four disastrous occasions, which led to massive trouble for banks:

– Great Depression 1929

– Depression of 1921,

– Panic of 1893,

– 1870s Banking Crisis

The Fed is contracting the money from the system through the Quantitative tightening (QT) mechanism. The credit crunch hit banks and soon other parts of the economy as many financial institutions prepare for contracting Loan to deposit ratio (LDR). Here is evidence from the latest quarterly bank reports.

First Republic Bank Loans +22.6% YoY, Deposits –35.5% YoY

JP Morgan Loans +6% YoY, Deposits –8% YoY

Wells Fargo Loans +6% YoY, Deposits –7% YoY

This picture goes for the rest of the industry, loans up, deposits down, leading to sustainability issues.

The inevitable price inflation from printing a couple of trillion dollars during the Covid-19 Pandemic has forced the Fed to allow interest rates to rise significantly. Now, banks find they don’t have enough interest income from those older low-interest securities—to pay the bank’s bills in the current era of higher interest rates. The first problem signs of this yield mismatch have appeared with the failures of Silicon Valley Bank and Signature Bank.

Banks are, therefore, reluctant to raise interest rates on deposits. This has led to a historic decline in bank deposits as investors seek yield in other parts of the market, such as money market funds.

Hence banks will have to cut back on loans to account for lower deposits, leading to fewer mortgages, loans, and ultimately money in the economy, resulting in tightened lending conditions.

This has been happening in the last quarter and will likely continue. Banks are tightening credit in response to Fed rate hikes, economic uncertainty, and money supply contraction, nearing the contractionary levels experienced during the Pandemic, GFC, Dotcom Bust, and Gulf War Recession.

Not only that but apart from the tighter standards, there is also a weaker demand for commercial and industrial (C&I) loans to large and middle-market firms as well as small firms over the first quarter, as (re)financing at those higher rates is quite expensive.

This suggests a significant slowdown in lending that might lead to a wave of layoffs/bankruptcies that could culminate in a recession in the second half of 2023.

On the upside, inflation should continue to roll over. However, given the velocity at which M2 has fallen, the risk is that the economy could enter a deflationary period.

This will put much pressure on the Fed to reverse course and start QE (cut rates and boost money supply), something that the markets are not only attaching a high probability but are almost certainly expecting to happen before the end of the year.

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